Asian banks on watch with trillion-dollar Libor transition

Singapore

TRILLIONS of dollars globally are priced to Libor, the scandal-tainted benchmark that is due to vanish by end-2021 - and this massive transition may catch Asian banks wrong-footed with the speed of its phase-out.

The financial markets are transitioning to alternate reference rates to better reflect true borrowing costs, with this seismic move estimated to be of the same scale as the euro transition.

But audit group EY told The Business Times that lenders here are just not as prepared for the impact of the Libor transition on their balance sheets as their global peers.

Its global IBOR (Interbank Offer Rates) leader Roy Choudhury, when asked how prepared Asian banks are for the transition, told BT: "I would say we're at phase zero.

"The (three-year) timeline is aggressive, so the wait-and-watch strategy is probably not the best strategy."

The Libor - short for the London Interbank Offered Rate - is used as a reference rate for loans and derivatives. Singapore's own interbank benchmark (Sibor), sees correlation with the US-dollar Libor.

The UK Financial Conduct Authority (FCA) had said in 2017 that it would kill Libor, the interest-rate benchmark on which some US$350 trillion of transactions are priced. This followed the rigging scandal in 2012, which led to some US$9 billion in fines levied on banks for attempting manipulation of the Libor, rocking the credibility of the major benchmark.

Still, the manipulation concerns ran "in parallel" to the broader problem, said EY's Mr Choudhury. While Libor is the dominant benchmark for pricing of loans and derivatives, it has not reflected many actual transactions in the post-crisis period. This has left Libor vulnerable to the manipulation that occurred in 2012.

Libor relies on a panel of appointed banks that submit rates at which banks would supposedly lend funds to one another. Mr Choudhury said: "The question asked to the banks is: 'If you were to borrow in the inter-bank market, what is the price of the borrowing?' The question doesn't ask what the actual cost of borrowing is; it's asking for your opinion on the expected cost of borrowing.

"Since the crisis, the number of transactions in the inter-bank market has reduced. So increasingly, firms had to use expert judgement in their Libor panel submissions. Libor was of declining relevancy."

Indeed, data cited by the FCA showed that for one set of Libor rates, the panel banks likely executed just 15 qualifying transactions in that currency and lending period - for all of 2016.

With this critical Libor transition, market watchers have warned of the repercussions of being caught unaware in this process, with American investment-management firm Pimco recently stating in plain terms that there is "no room for error".

Against this backdrop, EY's Asean financial services risk advisory leader Gary Mellody said some of the global banks have already gone though board-level impact analyses. "In the Asia-Pacific, you haven't seen that yet."

As a rough gauge, a typical global institution could have up to 25 per cent of its lending portfolio linked to Libor that is maturing post-2021, said Mr Choudhury.

There are no clear estimates for the Asian banks' direct exposure to the Libor transition, though the concern is likely less on exposure but that of ensuring an orderly transition, BT understands.

Singapore banks are taking a wait-and-see approach, as the global transition is in a flux. And to be clear, global regulators are still watching the impact of new alternate reference rates.

The US will move towards using the US Treasury repo rate, which is priced against about US$800 billion in daily transactions.

Repo is short for repurchase and refers to a short-term borrowing contract in which a borrower sells a security to a buyer and must buy the security back from the buyer at a higher price - or the repo rate - at a future date.

As part of the transition, US government mortgage agency Fannie Mae in July issued US$6 billion of bonds linked to this repo-linked rate, known as the Secured Overnight Financing Rate, or Sofr. "It (Sofr) is a market observable rate, based on transactions that have happened," said Mr Choudhury.

Loans priced directly off Libor may be moved to be priced against Singapore's own swap offer rate (SOR), BT understands. The SOR, more often used for business loans, is derived by accounting for the exchange rates of the Sing dollar against the greenback for both spot and forward trades.

Mr Mellody added that for now, the Sibor will still hold as a reference rate. This comes as Singapore recently reviewed the Sibor benchmarking process. By early 2020, the rates submission processes will be fully tightened to account for panel banks' transactions for both unsecured interbank funding and wholesale funding. The inactive 12-month Sibor will be scrapped as well.

Executive director of the Association of Banks in Singapore (ABS) Ong-Ang Ai Boon confirmed to BT that Sibor will continue to function as a benchmark rate over the next few years, though ABS will watch how Libor will be replaced.

Still, one bank here pointed out that, with the end of Libor, the reasons to retain Sibor are not wholly attractive. "The SOR variant is a more likely survivor than Sibor in a post-Libor world. But there still remains much uncertainty in the process and timeline."

The challenge in using only SOR is that the higher odds of volatility embedded in SOR - with its exposure to forex swings - should make it inappropriate for mortgages. More work must then be done to develop SOR as an alternate reference rate in Singapore. Asian banks will also need to adjust contracts linked to derivatives used for currency hedging. Mr Mellody said the biggest workload for Asian institutions is in dealing with the impact on pricing major currencies such as the greenback and the sterling.

The cross-currency swap market references the Libor, and with the phase-out of the benchmark, traders may no longer be able to use a similar rate for both legs of a forex swap for a US-sterling swap, EY said. The US Sofr refers to secured borrowing, whereas the UK's alternate reference rate - the sterling overnight index average, or Sonia - reflects unsecured borrowing.

To add, the transition timing to alternate reference rates, or in the timing of publication of daily alternate reference rates across major currencies, is not harmonised yet.

All of these translate to more bumps to overcome in the FX swap markets, warned EY, even as global investment banks can now develop new derivatives products to help with the price discovery process.